Segregation: Definition, How It Works wIth Securities and Example

What Is Segregation?

Segregation is the separation of an individual or group of individuals from a larger group. It sometimes happens to apply special treatment to the separated individual or group. Segregation can also involve the separation of items from a larger group. For example, a brokerage firm might segregate the handling of funds in certain types of accounts in order to separate its working capital from client investments.

Understanding Segregation

Segregation became a rule in the securities industry in the late 1960s and was solidified with the advent of the Security and Exchange Commission's consumer protection rule, the Securities Exchange Act (SEA) Rule 15c3-3. Other rules require firms to file monthly reports regarding the proper segregation of investor funds.

The chief aim in segregating assets at a brokerage firm is to keep client investments from commingling with company assets so that if the company goes out of business, the client assets can be promptly returned. It also prevents businesses from using the contents of client accounts for their own purposes.

Segregated account management ensures that decisions made are according to the client's risk tolerance, needs, and goals. When funds are pooled or commingled rather than segregated, as with a mutual fund, investment decisions are made by the portfolio manager or investment company. On the other hand, the individual investor makes the decisions in their account held at a broker-dealer.

However, the brokerage firm must also monitor that the investments are suitable for each account, which falls under a rule called Know Your Client or Know Your Customer. Each of these individual accounts, as a group, is segregated from the firm's working capital and investments.

Examples of Segregation

Segregation applied to the securities industry requires that customer assets and investments that are held by a broker or other financial institution are kept separate—or segregated—from the broker or financial institution's assets. This is referred to as security segregation.

A brokerage firm that holds custody of its client's assets may also own securities for trading or investment. Each of these types of assets must be maintained separately from the other. The bookkeeping must be separate as well. Segregation might also be applied to assets that need to be tracked independently for accounting purposes.

There are also separate, or segregated, accounts that have different privileges and requirements than those held more generally by a larger group. Portfolio managers, for example, will often create portfolio models that will be applied to the majority of the assets under management. However, discretionary accounts may be introduced for investors with different requirements (such as investment objectives and risk tolerance) that are different from the other investors in the portfolio. These separate accounts are allowed deviations from the portfolio manager's usual strategy and are segregated from the larger pool.